I have a mentor, a retired European investor with whom I correspond from time to time. He has kindly permitted me to reproduce below a recent letter:

I’ve met many rich men in my long life, and I must confess that the category of rich man that most annoys me is the real estate landlord, simply because he seems to do the least work for his wealth. I’m not talking about visionary developers who create buildings out of nothing, but rather those who allocate their capital—or, often, the capital of their ancestors—to existing real estate, leverage it up, and sit back passively for years collecting rent checks and refinancing along the way, secure in the knowledge that the government offers explicit and implicit subsidies to their “efforts.” It’s both amazing and annoying how well you can compound wealth over time in this way, provided you’re lucky enough to avoid a downturn in which your leverage kills you.

This feeling of annoyance has led me to ruminate on who possesses true skill in the art of passive real estate investment. Meaning, those who can generate returns over and above the return attributable to the “market return” of real estate assets, magnified by leverage. Call it “real estate alpha” if you like.

Now you may object that you cannot really calculate the alpha of an asset that does not trade as a liquid security. Technically that’s right, but conceptually it’s a little backwards, since the alpha of the bit of capital known as a publicly traded security ultimately depends on what happens to the capital within the corporate veil of the entity that issues the security. In other words, the risk-adjusted returns of the capital invested in buildings in the end determines the risk-adjusted returns of the pieces of paper that represent claims against those buildings. So if you can’t quite calculate the alpha of a building, you can at least think about where it comes from, which is more important than the precise number.*

*(This explains why Berkshire Hathaway has such a high long-term alpha despite the fact that Warren Buffet has likely never calculated the metric in his life. He doesn’t spend any time thinking about alpha itself, but he spends tremendous time thinking about what produces it.)

Which brings me to an childhood friend of mine. Like me he was born in Trieste, and like me he was sent to the US just before the Second World War. Unlike me, when he returned to Europe he found himself an orphan, and having retrieved what remained of his family fortune in a numbered account in Switzerland, he decided to live in Rome, since Trieste was no longer part of Italy.

Traumatized by his experiences, and being of a bookish disposition, he had no desire to embark upon an active business career.He simply wanted to earn the highest long-term risk-adjusted return he could from a passive investment of his capital (of course he never said the words “I want to earn the highest long-term risk-adjusted return…” but I’m here to tell you, on behalf of old men everywhere, that the concept existed long before the economists invented the term for it). This led him to real estate, historically considered a reputable place for Europeans to invest their capital passively.

At the time—we’re in about 1948 now—Italy was still in a postwar recession, and much of the country lay in ruins. However, Marshall Plan aid was on its way, and the city of Rome was still intact, with its beautiful buildings still there, it’s reputation as a style capital still there, and of course, with the Catholic Church still there. It’s not called the Eternal City for nothing.

Near the famous Spanish Steps lies a narrow street called Via dei Condotti, which had long been a haunt for tourists and expatriates. I believe at the time it was just starting to house some fashion retailers. My friend decided to focus his search there.

He found that he could buy, with generous financing, several buildings possessing ground floor retail space. They were beautiful old buildings, which by definition are impossible to replace, and he reasoned that their combination of location, exclusivity, and beauty would appeal to tenants for whom aesthetics and exclusivity are of primary concern—which describes most fashion houses then and now.

The price he would pay, and the financing that was available, combined to produce about a 15 percent initial leveraged yield, all of which was distributable to the equity. We tend to forget this nowadays, but a high initial distributable yield is the chief contributor to most very long-term equity returns.

My friend then decided that given Italy’s predicament, its economy could not get much worse than it already was, and that therefore his rents would probably not decrease from their initial level. So his 15 percent yield was both high and possessed limited downside risk, which is the main risk you want to adjust for when estimating risk-adjusted returns.

As far as upside, he predicted that he was likely to achieve growth in rental income from any one or more of the following sources:

1) Italy’s economic reconstruction, which would over time be reflected in rents.

2) The return of Catholic pilgrims to Rome, many of whom chose to shop while in the city.

3) The overall return of tourism to Rome.

4) And last but not least, the secret best friend of the passive real estate investor: inflation. Simply put, when the cost of your liabilities is fixed while the productivity of the asset financed by those liabilities rises in nominal terms with inflation, then inflation serves to increase your real rate of return. My friend was no macro forecaster, but we who grew up in Trieste in the 1930s had a Germanic sensibility, and we knew all about the Weimar hyperinflation and were sensitive to it. Furthermore, Italy had a reputation during the Mussolini years of generating a lot of inflation in order to finance fiscal deficits. So my friend had a bias towards more future inflation rather than less.

To sum up, my friend had no special forecasting abilities, but he believed his initial yield was satisfactory, that its downside risk was limited, and that he had several sources of potential upside. In other words, he thought the buildings in question offered a good risk-adjusted return. So he bought about seven of them, if I remember correctly.

As it turned out, everything turned out about as well as could be expected. The 15 years following his purchase were the years of the postwar economic miracle in Italy, and the country that had looked like this turned into a country that looked like this and this. The Church once again received her pilgrims by the thousands, and general tourism returned with a venegance, helped by the dawning of the Jet Age and the advent of the Japanese Tourist. The Italian government obliged its many property-owning citizens with a good dose of inflation. And last but not least, my friend realized to his surprise that he preferred the life of an active landlord rather than a passive one. He chose his tenants carefully, worked with them closely to maximize the value of their space, and played an important yet anonymous part in making Via dei Condotti into the legendary shopping destination it is today. I believe he also managed to negotiate percentage rents with some of his tenants, which entititled him to be paid a percentage of the tenant’s revenue above a certain threshold. The better he chose his tenant, the better he did—and he managed to do surprisingly well in this regard, for a man of bookish temperament.

My friend’s annual rents compounded at a magnificent nominal rate, he refinanced along the way and reinvested the proceeds wisely, and by the mid-1960s found himself a very rich man. He sold most of his properties in the late 1960s, and like many wealthy Italians, has maintained a low profile every since.

I’m sure those who owned property on Fifth Avenue in 1948 ended up doing very well, as did those who owned on Rodeo Drive, or Bond Street, or the Rue de Faubourg Saint-Honore. But with the possible exception of those who owned in Tokyo’s Ginza district, I can’t think of anyone who earned more alpha from passive real estate ownership during this period than my friend. Every time I see a new headline about some new condominium in New York being bought “as an investment” at some crazy price, I think of him with a smile.

Yours Sincerely,

J

P.S. In his 2013 letter to shareholders, Warren Buffett describes a personal real estate investment he made in the early 1990s. While his story is not quite as dramatic as my friend’s, the contours of the investment analysis are identical: the focus on high initial earnings yield, the assurance of downside protection, the scarcity and prime location of the property in question, the prospect of both nominal and real rental growth, and the intelligent use of leverage—all combining to produce a very good return on invested equity.

P.P.S. Thought question: On a fundamental basis—that is to say, comparing total dividends over time to the initial equity outlay and measured on a percentage basis—what is the most profitable hotel property ever?

What about in the United States? I have my guess for this one—I’ll give you a hint: it was developed by one of the great unsung capitalists of the 20th century, a man nearly forgotten, but whose name lives on in various institutions. If you live in California you probably encounter his name often.